What is the Cost of Capital?

​The Cost of Capital is also known as the Weighted Average Cost of Capital or WACC. It is the weighted average cost of both debt and equity.The WACC for the average US company is fairly low these days; primarily due to historically low interest rates.The risk-free rate, as measured by long term US government bonds, is only 2.8%.

Measuring the Cost of Capital is important for three reasons:

1.The Cost of Capital is the gold standard used to answer the question ‘how much ROI is enough?’. WACC is the minimum acceptable rate of return necessary to earn shareholder value.ROI must exceed WACC to create shareholder value.The Cost of Capital in the average US company is currently around 6%.

2.In any industry, efficient markets drive the returns on investment opportunities toward the industry average Cost of Capital. Arguably, many industries are not efficient. However, when finance managers see investment proposals with promised returns of ten, twenty or even fifty times the company’s WACC they are typically skeptical.

3.Using discount rates that are higher than WACC can result in a significant reduction in potential project NPV of anywhere from 20% to 30% (see data table and graph below)